Federal Reserve Chairman Jerome Powell faces the toughest task since Chairman Paul Volcker tamed the Great Inflation of the 1970s and early 1980s. And a lot of the pressures driving the most virulent inflation in decades are well beyond monetary policy to control except with radical measures.
Before Russia invaded Ukraine, pandemic disruptions to shipping, chip shortages and domestic food-supply issues were expected to persist.
Now, biting sanctions are backing Russian President Vladimir Putin into a corner. He can’t relent without risking his grasp on power and ultimately ending up at the International Court of Justice in The Hague on trial for war crimes.
Crucial supplies cut off
Russian troops will sooner or later occupy the major Ukrainian cities—even if they have to level them first and then live in ruble and tents. However, quelling resistance in the countryside will require as many as 500,000 Russian troops. Even with a cease-fire, sanctions and disruptions to Russian and Ukrainian exports will persist.
Traders and shippers are shunning Russian cargoes and ports, putting at risk supplies of oil, wheat and other vital commodities that come out of Black Sea ports. Also, Russia exports palladium critical for making catalytic converters in automobiles, and Ukraine supplies half the world’s neon gas critical to the manufacture of semiconductors.
All of this exacerbates upward pressures on U.S. prices for gasoline, cars, electronics, agricultural fertilizer and herbicides, groceries and countless other products.
On the demand side, moderately raising the federal funds rates won’t help much. Consumers have flush balance sheets to support retail sales, and beefing up NATO defenses will require larger defense spending in both the United States and Europe—unless, which I doubt, they lower their guard to Chinese adventurism in the Pacific.
Apparently, Powell is seeking a soft landing—to somehow recapture 2% inflation without slowing economic activity too much. History teaches inflationary pressures this serious are usually defeated only by a significant economic slowdown—essentially reducing aggregate demand to align with aggregate supply.
Like Chairman Arthur Burns in the 1970s, Powell doubts the link between the money supply and inflation. But such skepticism is only warranted when aggregate supply is flush—specifically, not at times like these.
That won’t cut it
Nevertheless. we can expect moderate increases in interest rates—perhaps a quarter point and occasionally a half point as pressures build—at each Fed meeting, and that won’t cut it.
In the 1970s, non-Euclidean economics and monetary-policy gradualism didn’t work for Burns and his successor Chairman William Miller. The Great Inflation was only broken when Volcker raised the federal funds rates by 7 percentage points in eight months. His economy quickly sunk into recession, he eased back as activity recovered, and then took the pedal to the metal by raising the policy rate all the way to 19%.
The Fed will soon start removing some liquidity from the economy by shrinking its $8 trillion hoard of Treasury and mortgage-backed securities at a steady and predictable pace, but the principle tool for curbing inflation will be targeting the federal funds rate.
The minutes of the December meeting expressed the views that there is less uncertainty about the impact of interest rate hikes than on shrinking bondholdings, rate increases are easier to communicate to the public, and it’s easier to adjust rate increases than the process of running down the balance sheet.
Those concerns only apply if the policy choice is between a steady rundown in the balance sheet or periodically adjusting the flow without a specific target or objective.
If the Fed set a floor for the 10-year Treasury rate
and adjusted the pace of longer-term securities sales to ensure the integrity of that floor, it could target both a narrow range for the federal funds rate
and a minimum slope for the Treasury yield curve. The policy objective could be expressed as the “target floor for the 10-year Treasury rate,” and it would be adjusted upward along with the federal funds rate over time.
Target the 10-year yield
During the last two tightening cycles, raising the federal funds rate failed to boost the 10-year Treasury rate or other long rates very much, because foreign money came into U.S. bond markets as U.S. rates attempted to inch up. With global conditions so uncertain, that is likely to happen again if measures to enforce a 10-year Treasury rate floor are not adopted.
Maintaining a positively sloped yield curve is essential to cooling the pace of inflation for durable goods and housing and restoring calm to equity markets, and those impacts are more direct and predictable than relying on the federal funds rate.
Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
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